Chapter 17

Capital Structure

Capital Structure: Introduction

Capital structure refers to the combination or mix of debt and equity which a company uses to finance its long term operations.

Approach To Capital Structure

Approaches to Capital Structure

Relevance Approach meaning financial leverage does influence value of firmNI Approach

Irrelevance Approach meaning financial leverage does not influences EPS, Cost of capital and financial risk & thereby value of firm NOI Approach

Compromising approach meaning financial leverage lessens cost of capital only up to a specific point, beyond which cost rises. Traditional Approach

Theories of Capital Structure

The theories of capital structure suggests the proportion of equity and debt in the capital structure. Assumptions of the theories are: (i) There are only two sources of funds, i.e., the equity and the debt. (ii) The total assets of the firm are given and there would be no change in the investment decisions of the firm. (iii) EBIT (Earnings before Interest & Tax)/NOP (Net Operating Profits) of the firm are given and is expected to remain constant. (iv) Retention Ratio is NIL, i.e., total profits are distributed as dividends. [100% dividend pay-out ratio] (v) The firm has a given business risk which is not affected by the financing wise. (vi) There are no corporate or personal taxes. (vii) The investors have the same subjective probability distribution of expected operating profits of the firm. (viii) There are no transaction costs.

Definitions and symbols used

E= Total Market Value of the Equity D= Total Market value of the Debt V= Total Market value of the firm V= D+E NOP = Net Operating profit or EBIT NP= Net profit or PAT Kd= Cost of debt = I/D Ke= Cost of equity= D1 +g P Growth rate= 0 So Ke = D/P Since payout ratio is 100 % D= earnings or Dividends Ke= E/P

 Multiplying both numerator and denominator by the number of shares we get Ke= E *N= EBIT-I P*N S

Ke = NP/S= net income available to shareholders/ Total market value of equity shares Ko= w1kd + w2 Ke = [D/(D+E)]* kd +[ E/(D+E)] * ke = NOP = EBIT V V

Net Income Approach

Suggested by David Durand Capital Structure matters Assumptions 1. The use of debt does not change the risk of investors and therefore cost of debt (Kd) and cost of equity (Ke) remains same irrespective of the degree of leverage 2.Cost of debt is less than the cost of equity 3. The corporate income tax does not exist

Net Income (NI) Approach

According to NI approach both the cost of debt and the cost of equity are independent of the capital structure; they remain constant regardless of how much debt the firm uses. As a result,
ke, ko ke Cost

the overall cost of capital declines and

kd

ko kd

the firm value increases with debt. This approach has no basis in reality; the optimum capital structure would be 100 per cent debt financing under NI approach.
Debt

Net Operating Income Approach

Capital Structure does not matter The market value of the firm is not affected by the capital structure changes The market value of the firm is found out by the capitalising the NOI by the overall cost of capital which is constant V= NOI V=B+S Ko Ko depends on business risk of the firm which is constant NOI depends on the investments made by the company and not on the capital structure decisions NOI and Ko are constant so value of the firm is constant regardless of leverage.

Assumptions
The market capitalises the value of the firm as a whole. Thus the split between debt and equity is not important The value of the firm is obtained by capitalising NOI by Ko which depends on business risk . If business risk is constant K0 is also constant The use of debt increases the risk of shareholders. So ke increases with the leverage and eats completely the advantage of low cost debt Cost of debt remains same regardless of leverage Corporate income tax does not exist

Net Operating Income (NOI) Approach

According to NOI approach the value

of the firm and the weighted average

cost of capital are independent of the firms capital structure. In the absence of taxes, an individual holding all the debt and equity securities will receive the same cash flows regardless of the capital
Debt ko kd Cost ke

structure and therefore, value of the company is the same.

Traditional Approach
A practical View point; a midway approach. The value of the firm can be increased or cost of capital can be reduced by a judicious mix of debt and equity capital. Cost of capital decreases up to a certain degrees of leverage then it remains at the same level for certain degrees of leverage and thereafter it rises sharply with the leverage. So optimal capital structure exists when the cost of capital is minimum or the value of the firm is maximum.

 In the first stage cost of equity remains constant or rises slightly with the debt. But when it increases it does not increase fast enough to offset the advantage of low cost debt.Cost of debt also remains same or rises slightly with the leverage.As the copst of debt is less than the cost of equity ,increased use of debt reduces the overall cost of capital during the first stage

Stage II
Once the firm has reached the certain degree of leverage increased use of debt does not result in the fall in the overall cost of capital.This is due to the fact that benefits of low cost debt are offset by the increase in the cost of equity.Within this range cost of capital will be minimum or the value of the firm will be maximum.

Stage III
Beyond a certain point use of debt has unfavourable effect on cost of capital and value of the firm.This happens because the firm would become more risky to the investors and hence they would penalise the firm by demanding higher return .Here advantages of using low cost debt are less than the disadvantages of higher cost of equity.So overall cost of capital increases with the leverage and the value of the firm decreases. Thus the overall cost of capital decreases with the leverage reaches one minimum point and thereafter increases with leverage.

The Irrelevance Approach

Those who believe in perfect market conditions are not of view that the issue of capital structure is irrelevant, implying that any change in capital structure has no influence on the value of corporate wealth. This view was explained at great length by Modigliani and Miller(1958).

Assumptions of the MM Approach

1. There is a perfect capital market. Capital markets are perfect when i) Investors are free to buy and sell securities, ii) They can borrow funds without restriction at the same terms as the firms do, iii) They behave rationally, iv) They are well informed, and v) There are no transaction costs. 2. Firms can be classified into homogeneous risk classes. All the firms in the same risk class will have the same degree of financial risk. 3. All investors have the same expectation of a firms net operating income (EBIT). 4. The dividend payout ratio is 100%, which means there are no retained earnings. 5. There are no corporate taxes. This assumption has been removed later.

 The Arbitrage Argument The term arbitrage refers to an act of buying a security in one market where the price is less and simultaneously selling it in another market where the price is more to take advantage of the difference in price prevailing in two different markets. Arbitrage process helps to bring in equilibrium in the market Because of arbitrage a security cannot be sold at different prices in different market

 If the market value of the two firms are not equal investors of the overvalued firm would sell their shares, borrow additional funds on their personal accounts and invest in undervalued firm in order to obtain the same return on smaller investment. The use of debt by the investor for arbitrage is termed as homemade or personal leverage Arbitrage would be continuing till the market prices of two identical firms become identical

 There are 2 firms L & U which are identical in all respects except that the firm L has 10 % Rs 500000 debentures . The EBIT of both the firms is Rs 80000. The cost of equity of the firm L is higher at 16 % and firm U is lower at 12.5 %

L Co EBIT Less: Int NI Cost of Equity(Ke) Market value of shares Market value of Debt Total value of the firm Ko= EBIT/V 80000 50000 30000 0.16 187500 500000 687500 11.63%

U Co 80000 80000 0.125 640000 640000 12.5 %

Working of Arbitrage
Suppose there is an investor X who holds 10 % of the outstanding shares in the firm L The value of share holding is Rs 18750 ( 10 % of 187500) His share in the earnings is Rs 3000 (10 % of 30000) Mr X will sell his share holding in firm L and invest money in firm U The firm U has no debt in the capital structure and hence the financial risk of to Mr X would be less in firm U than firm L

 In order to have the same degree of financial risk in firm U , X will borrow additional funds on his personal account which is equal to his proportionate share in firm L s debt ( Rs 50000 @ 10 %) So He has substituted personal leverage in place of corporate leverage.

Firm U Firm L Net Return = 3000

Total funds available 50000+18750= 68750 10 %invested in firm u = 64000 Balance left (surplus) = 4750 Return available= 8000( proportionate 10% of NI) Less Int = 5000 Net Return = 3000
He has 4750 surplus available with him so his income will be more than 3000( inclusive of some investment income on 4750)

 This opportunity to earn extra income will attract many investors. The gradual increase in sale of shares of L co will push its prices down and tendency to purchase shares of U co will drive its prices up. This will bring the market value of the 2 firms equal At this stage the vale of 2 firms is equal Ko are same so Ko is independent of financial leverage.

Criticism of MM hypothesis
1. Non substitutability of Personal and Corporate Leverage : I) Different borrowing rates for the corporate and the individuals Inconvenience of Personal leverage; Leverage Capacity 2. Transactions cost 3. institutional Investor 4. Availability of full information 5. Corporate Taxes

Effect of Taxes on MM Hypothesis

Leverage may increase the value of the firm The interest is tax deductible so the levered firm will have higher cash profit to be distributed among the shareholders as compared to an unlevered firm

A ltd EBIT 150000

B ltd 150000

-Int
PBT - Tax @ 30 % PAT Total cash flow for debt + equity shareholders Interst Tax shield

150000 45000 105000 105000

50000
100000 30000 70000 120000 15000 ( int * tax rate)

The value of the levered and unlevered firm differ only with respect to the interest Tax shield available till perpetuity Value of Levered firm= Value of Unlevered firm + PV of perpetuity of Interest tax shield

 Vu= EBIT(1-t) Ko VL= Vu+ PV of interest tax shield VL= Vu + Debt * T

Factors Determining Capital Structure

1. Trading on Equity 2. Nature of Enterprise: Firms with stable earnings can rely more on debt 3. Size of Company small company will rely more on equity as it is not possible to attract debt capital. 4. Minimization of Risk: Capital structure must be framed so as to minimize the business and financial risk. 5. Retaining Control: is affected by the extent to which existing management of the company desires to maintain control over the affairs of the company. 6. Purpose of financing : if purpose is productive the firm may use debt capital otherwise equity.

Requirement of investors: the company requiring large amnt of capital must issue different kinds of securities to suit the requirement of investors Period of Finance: if fund for long time required equity should be preferred and for short time short term debt may be used Market Sentiments: when there is boom in the capital market it is easy to issue equity capital.but when in the market bear conditions prevail only debt instruments with good credit ratings can be issued Cash flow ability : issue of debt depends on the future cash flow ability of the company. Floatation Costs: Retained earnings do not involve foatation costs. Floatation costs of shares is more than debts.Further floatation costs are less when the company issues securities on private placements basis instead of public issue.

Features of a Sound Capital Structure

Perfect trade off between risk and return. Minimum cost of capital Sufficiency of cash flow to service debt. Maintenance of industry norms. Flexibility.